Salvato Law Offices successfully objected to a default interest provision in a commercial loan that resulted in the Bankruptcy Court declaring that the provision was an unenforceable penalty under California Civil Code Section 1671(b). As a result, more than $10 million in default interest was eliminated from the commercial loan.

The following is an independent case analysis of the matter from Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. It has been reproduced in full.

The following is a case update prepared by Professor Dan Schechter, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

A California bankruptcy court has held that a default interest rate provision was an unenforceable penalty because the loan agreements did not contain any estimate of the probable costs to the lender resulting from the borrower's default. [In re Altadena Lincoln Crossing LLC, 2018 Westlaw 3244502 (Bankr. C.D. Cal.).]

FACTS: A lender and a commercial borrower entered into two related real estate construction loan agreements, both of which contained clauses increasing the base interest rate by 5% in the event of default. The agreements also contained late fee provisions, which were intended to compensate the lender for any additional administrative costs arising from late payments. The principal amount of the obligation eventually rose to about $26 million.

Several years later, when the project ran into difficulty, the parties executed a series of forbearance agreements; several of those agreements contained "default interest forgiveness provisions," under which accrued default interest would be forgiven if the debtor paid the outstanding balance of the loan on the extended maturity date.

After the developer filed a Chapter 11 petition, the lender sought to recover interest at the default rate set out in the parties' governing documents. The debtor objected, claiming that the default rate of interest was an unenforceable penalty under California Civil Code §1671(b).

REASONING: The court sustained the objections and awarded the debtor attorney's fees for its successful objection to the claim. After reviewing the applicable case law, the court observed:

The standard is whether the default interest provisions were the result of a reasonable endeavor at the time the parties entered into the agreement to estimate a fair average compensation for any loss that might later be suffered and not whether the default interest figure eventually produced appears after the fact to be reasonable in relation to the principal amount of the loan.

The lender argued that because the borrower had waived its defenses to the default interest provision in the forbearance agreements, the borrower could not challenge that provision. The court disagreed:

[The lender] has cited no authority for the proposition that an unenforceable penalty will be rendered enforceable if the borrower signs an acknowledgment that it is obligated to pay the penalty or if the borrower agrees to waive any defenses it may have to the obligation to pay this amount. Moreover, in each Forbearance Agreement . . . , [the lender] agreed to forgive default interest provided the obligation was repaid at maturity, effectively creating a new liquidated damages provision that would need to be examined to ascertain whether it was an unenforceable penalty. As the amount of accrued default interest was larger each time [the parties] executed a new forbearance agreement, it would become harder and harder for the Court to find a reasonable relationship between the liquidated damages amount and any damages that the parties anticipated would flow from breach of the Forbearance Agreement. The Court finds no reason to conclude that the drafters of section 1671(b), who intended for the analysis to be performed at the inception of a loan, would have meant for the court to re-examine the result produced by a liquidated damage provision each time the parties extended the maturity date of a loan or any other due date for performance.

The lender next argued that because a 5% default interest provision is the admitted industry standard, the provision was reasonable. The court again disagreed:

[W]hile it might be relevant to the issue of reasonableness to know that other lenders typically charge 5 percent or more as default interest on construction loans, it is not dispositive. Industry standard or custom in the industry is different from reasonableness in this context. (The Court is not in a position to determine, and the parties have not litigated whether, lenders make a practice of imposing a default interest rate that is intended to function as a penalty to incentivize borrowers to pay in a timely fashion or whether they select default interest rates in an effort to provide compensation for anticipated losses.)

The court noted that there was no evidence the parties had negotiated the 5% provision or had attempted to quantify the probable loss to the lender resulting from a default:

[T]he selection of the 5 percent default interest rate was not the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that might be suffered by [the lender] in the event of a default, in that the Debtor has established that there was no endeavor at all by either of the parties at the time they entered into the loans, let alone a reasonable endeavor, to estimate any losses that might be suffered by [the lender] in the event of a default. The default interest provision was selected arbitrarily pursuant to [the lender's] standard practice of utilizing a default interest rate in this amount.

The lender's expert testified that the probable loss in value resulting from a default justified the imposition of a 5% default rate, but the court reasoned that just because there is a correlation between the borrower's default and the lender's losses does not mean that the default caused the losses:

[T]here is no reason to believe, in this case or in any case, that a borrower’s default increases the risk that a lender will not receive payment of its principal. Such [an argument] is an invitation to the court to fall into the trap of confusing correlation with causation. The only conclusion that this court can legitimately draw from [the expert's] report is that, as a statistical matter, lenders recover less on loans that fall into default, but his report does not have any tendency whatsoever to establish that defaults cause a loss of principal or even a greater risk of loss of principal. In fact, as a logical matter, it is equally if not more likely that the causal relationship is the other way around, namely, that a borrower who lacks the ability to repay a loan in full or who owns collateral that will not produce enough to pay off the debt in full through sale, foreclosure or refinancing is more likely to default than a borrower who has sufficient resources to pay off the loan either from other sources of cash or by monetizing the value of the collateral. The factors that lead a borrower to fall into the former camp (borrowers who can pay) rather than the latter camp (borrowers who cannot pay) are likely to be present at the inception of the loan and are not themselves caused by the borrower’s default. Only when the loan agreement itself imposes adverse financial consequences after a borrower defaults, as, for example, by increasing the interest rate by 5 percent, does the default itself make the borrower’s financial condition more bleak than it already was.

AUTHOR'S COMMENT: This is a very well-written and well-researched opinion by a highly respected bankruptcy judge. Given the amount of money involved, I predict an appeal, and I predict affirmance. If so, this opinion will have a substantial impact on the real estate lending industry. As I will discuss below, I think that there are drafting techniques that lenders can use to increase the chances of collecting interest at the default rate, whether or not this decision is affirmed.

First, however, the inevitable quibbles: if an extra 5% default rate is the industry standard (as both the lender and the borrower argued), then isn't that a signal from the market that this is a reasonable provision? It is not outside the mainstream. It is not unprecedented. Shouldn't the concept of "reasonableness" take into account prevailing practices? That is certainly true, for example, in malpractice cases: the reasonableness of the defendant's behavior is assessed in light of customary norms. Why isn't that dispositive in this case?

Second, I am not sure that I agree with the court's analysis of correlation vs. causation. Isn't it true that the fact of default devalues the collateral? The project is immediately tainted; the lender is forced to foreclose, and foreclosures inevitably yield prices lower than fair market value.

Third, the court put the lender's expert into an impossible bind. He was tasked with showing the loss suffered by the lender as a result of the default. The court then used his own testimony to show that the lender could have estimated the probable losses from default at the outset of the transaction: "[T]he ease with which [the expert] was able to perform the calculations contained in his expert opinion demonstrates that a loss of this kind, if it can be characterized as a loss, would not be costly or difficult to estimate at the inception of a loan." The error in the court's logic is that although hindsight may be 20/20, foresight isn't.

Note that the documents contained the usual late payment provisions, which were designed to compensate the lender for its losses resulting from late payments. In the court’s view, the mere existence of those late payment provisions undermined, in part, the lender's argument that the default rate was designed to compensate the lender for the same losses. But I would argue that the losses covered by those two different sets of provisions are not the same: the late payment fees deal with the lender's administrative costs, while the default rate provision is more properly aimed at the devaluation of the collateral resulting from the default.

And that, of course, points the way toward a couple of different solutions. The first, which I have long (and unsuccessfully) recommended, is to support the default interest rate provision with carefully-worded factual recitals, right in the body of the agreement, demonstrating as a factual matter why the provision is needed and why it is the parties’ best approximation of the anticipated losses.

Could the borrower later repudiate those factual recitals? Maybe not. See Cal. Evid. Code § 622: “The facts recited in a written instrument are conclusively presumed to be true as between the parties thereto . . . . " For a discussion of a case in which that drafting technique was successful, see 2015-30 Comm. Fin. News. NL 60, Liquidated Damages Claim for Default Interest Is Enforceable Because Promissory Notes Recite Difficulty of Ascertaining Lender’s Actual Damages.

Note that this solution (to insert appropriate recitals in the agreement itself) is ex ante. But the court suggested an intriguing after-the-fact technique, one which I have never seen before:

[I]t would not be costly or inconvenient for [the lender] to have calculated its actual administrative costs in overseeing and servicing a defaulted loan. It would be difficult to predict with any degree of certainty at the inception of a loan how much these costs would prove to be later, but [the lender] could readily have kept track of such information by, for example, requiring its employees to keep timesheets to reflect how much time they spent overseeing or servicing which loans, and could have included provisions in the loan agreement passing these costs along to the Debtor as they accrued.

Assuming that the court's novel post hoc solution is viable, I would add a couple of additional "pass-through" cost items: the devaluation of the property resulting from the default itself, and the "time value of money" cost resulting from the illiquidity of a set of loan documents connected with a failing project. To describe that latter concept in a different way, a lender that had anticipated selling off a performing loan is now forced to hold a non-performing loan on its books, tying up the lender's capital. The inability to re-lend that money is a lost opportunity that damages the lender.

Given the bankruptcy courts' perennial antipathy to default interest rates, I am surprised that the finance industry still uses bland and generic "one-size-fits-all" default interest provisions, without including anticipatory verbiage to forestall the borrower's inevitable liquidated damages attack.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.

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